RIA Compliance Blog
In this first quarter of the year, most investment advisers are working diligently to complete and file their annual updating amendment to Form ADV, including Part 2A, commonly called the “Brochure.” One of the most important requirements in drafting a Brochure is to make sure that all conflicts of interests, together with a description of how the conflict is mitigated or addressed, are fully and fairly disclosed. An administrative action brought by the SEC and settled last week illustrates, and should serve to underscore, the importance of identifying and disclosing such conflicts.
The SEC charged registered investment adviser Moors & Cabot (“M&C”) with breaching its fiduciary duty to investment advisory clients by failing to disclose conflicts of interest relating to revenue sharing payments and other financial incentives that the adviser received from two clearing brokers. The financial benefits included discounts, incentive credits and shared revenue that were contingent upon M&C meeting certain thresholds in total assets maintained in FDIC-insure bank deposit cash sweeps. M&C also received a share of margin interest the clearing firms charged to M&C’s clients who maintained margin loans. M&C also received a portion of postage and handling fees that one of the clearing brokers charged to its clients.
These revenue sharing arrangements and other benefits incentivized M&C to allocate its client’s assets to cash that would be swept into the sweep accounts, thus creating conflicts of interest. For instance, while other cash sweep options were available, M&C only received revenue sharing for certain FDIC-insured sweep accounts. Consequently, M&C selected the FDIC-insured accounts as the default option for its clients. Any decision whether to recommend a margin loan was likewise influenced by the fact that the interest on such loan would be shared with M&C. More generally, the decision to utilize the services of the particular clearing brokers, as opposed to other available clearing brokers, was influenced by the fact that these particular brokers were willing to share revenue with M&C.
Additionally, under the agreements with its clients, M&C was obligated to pay ticket charges to one of the clearing brokers. However, M&C also received discounts on those ticket charges provided its clients maintained cumulative minimum balances in the FDIC-insured sweep accounts. This further incentivized M&C to select the FDIC-insured accounts.
M&C failed to disclose these conflicts of interest in its Brochure or otherwise. As a result, M&C was charged with willfully violating Sections 206(2) and 206(4) of the Investment Advisers Act and IA Rule 206(4)-7. In the consent order resolving the charges, the SEC emphasized that an investment adviser is obligated, pursuant to its fiduciary duty, to disclose all material facts relating to how conflicts of interest could possibly affect the adviser’s advice to its clients. An adviser can only discharge its duty if, at a minimum, the conflicts are disclosed with sufficient specificity that would allow a client to give knowing consent, in light of the conflicts, to accept or reject such recommendation.
M&C agreed to pay approximately $1.5 million in disgorgement and interest, to pay a $375,000 civil penalty, and to create and pay the costs to administer a Fair Fund to equitably distribute the disgorgement payments.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.